FINANCIAL MISCONDUCT: What are mortgage-backed securities?
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FINANCIAL WRONGDOING: What is a mortgage backed security?
Mortgage-backed securities are a particular kind of Collateralized Debt Obligations (CDO), that we reviewed yesterday.
Yesterday we covered CDO’s and learned these investments used three levels of investors that each received a different level of risk and reward. The levels or tranche's allowed us to spread the risk from defaults. Spreading the risk is important to attract those investors with the kind of money we need to make this work.
Aside from home loans there are commercial real estate loans. And of course like home mortgages, these loans can be paid off sooner than expected and that is in and of itself a risk to the investor. So now let's introduce commercial mortgage-backed securities or CMBS's.
Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily properties (such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites). The properties of these loans vary, with longer-term loans (5 years or longer) often being at fixed interest rates and having restrictions on prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely pre-payable.
For instance pension funds aren’t supposed to invest in risky investments. Pension funds require low risk investments and those returns are expected to be lower. Hedge funds like to gamble and in return they expect a much higher rate of return. The three levels of investors, senior, mezzanine and equity created the levels of risk and return that attracts those with money to invest. From pension funds to hedge funds and everyone in between came to the CDO and MBS investors. And those investors who were precluded from assuming very risky investments relied, to some extent, on those holding senior level tranches along with the rating companies that rated the risks associated with various investments.
Ah yes, the rating companies!! What about those rating companies?
More later this week but for today that’s the basic discussion of mortgage backed securities.
What is a tranche?
Let's visit Wordsmith.org where today's word, lucky enough is tranche.
A.Word.A.Day
with Anu Garg
tranche
PRONUNCIATION: visit the site and you can hear the word pronounced.
(transh) 
MEANING:
noun: A portion, especially of money, investment, etc.
ETYMOLOGY:
From French tranche (slice), from trancher (to cut).
USAGE:
"Some of the banks, including Central Bank of India and Vijaya Bank, have already received the first tranche of capital."
Mergers of Public Sector Banks Favoured; Business Standard (Mumbai, India); Mar 31, 2009.